Financial Markets

Members commenced their discussion of financial markets with the observation that
central bank policy actions, along with developments in Greece, had been the
main focus of markets over the past two months.

Members were briefed about the announcement by the European Central Bank (ECB) of
a large sovereign bond purchase program in January, following its assessment
that its existing measures would not be sufficient to prevent inflation from
remaining well below 2 per cent for a prolonged period. Starting
in March, the ECB plans to purchase €60 billion of securities each
month, well above the current rate of purchases of private securities; sovereign
bonds would be bought in proportion to member countries' contributions
to the ECB's capital. Debt purchases would continue until there was a sustained
increase in inflation, but they would end no earlier than September 2016. This
would increase the size of the ECB's balance sheet past its 2012 peak of
€3.1 trillion. While less than the US Federal Reserve's maximum purchases
of US$85 billion a month, on an annualised basis the ECB's purchases would
be equivalent to around 7½ per cent of the euro area's
annual GDP, compared with 6 per cent of US GDP for purchases by the
Federal Reserve (and 16 per cent of Japanese GDP for purchases by
the Bank of Japan).

Members noted that the Federal Reserve continued to indicate that it expected to
start increasing its policy rate around the middle of this year, but financial
markets had pushed back expectations for the first rate rise in the United
States to around the end of the year. A number of central banks had eased policy
in recent months in response to the effect of lower oil prices, including the
Reserve Bank of India and the Bank of Canada. Markets had also pushed back
expectations for policy tightening by a number of other central banks. In contrast,
the central banks of Russia and Brazil had increased their policy rates.

The Swiss National Bank (SNB) abandoned its exchange rate ceiling against the euro,
which had been in place since September 2011, and lowered the rate on bank
deposits at the SNB by 50 basis points to −0.75 per cent. The
SNB's announcement noted that divergences between the monetary policies
of the major currency areas had increased significantly. The move surprised
markets, resulting in considerable market volatility and the bankruptcy of
several foreign exchange brokers.

Members noted that sovereign bond yields in the major markets had fallen significantly
since the December meeting. The falls had occurred across the yield curve but
were particularly pronounced at longer maturities, with yields on 10-year bonds
in the United States falling back to around 1.6 per cent and those
in Germany and Japan reaching historic lows of 30 and 20 basis points, respectively.
At these levels there was very little, if any, compensation for term risk.
For maturities up to five years, yields on bonds issued by Japan, Germany and
most of the core euro area economies, as well as Sweden and Switzerland, had
fallen below zero. Yields on Australian government bonds had mostly tracked
global developments and had also fallen considerably, with the 10-year yield
declining to a historical low below 2½ per cent.

The declines in global bond yields reflected a number of factors but the extent of
the decline in yields was difficult to explain. The large bond purchases by
major central banks had clearly contributed but so too had a reduction in bond
supply, reflecting a narrowing of fiscal deficits in a number of countries.
Concerns about the global growth outlook and the risk of sustained low inflation
following falls in the oil price had also played a role.

Members noted that the Greek authorities had indicated that they planned to restructure
the country's debt, most of which was owed to official sector institutions.
Greece had nonetheless also indicated a desire to remain part of the euro area.
The current European assistance program expired at the end of February and
markets had been closed to Greece since the recent election. Members also noted
that the critical issue in the near term was not so much the obligations of
the Greek Government but rather the funding of Greek banks. To date, there
had been minimal spillover from developments in Greece to other markets.

There had been sizeable movements in exchange rates since the December meeting, reflecting
the increasingly divergent paths of monetary policy among the major advanced
economies. Most notably, the Swiss franc had appreciated by around 15 per cent
against the euro since mid January. While the US dollar had depreciated against
the Swiss franc, it had also appreciated further against most other currencies
since the December meeting (including by around 10 per cent against
the euro). The renminbi had been little changed against the US dollar over
much of 2014, but had depreciated somewhat since the December meeting.

The Australian dollar had depreciated by around 9 per cent against the US dollar
since the December meeting. On a trade-weighted basis, the Australian dollar
was around 4 per cent below its early 2014 levels, notwithstanding
significant falls in commodity prices over the intervening period. The depreciation
of the Australian dollar against the US dollar and renminbi had been partly
offset by its appreciation against the yen and euro.

Equity prices in advanced economies had been broadly unchanged since early December,
notwithstanding a strong rally in European share prices following the announcement
of the expansion of the ECB asset purchase program. Global equity prices had
risen moderately over 2014, led by an 11 per cent increase in US
equity prices, while Chinese equities had significantly outperformed other
emerging markets since mid 2014.

In Australia, equity prices recorded a smaller rise over 2014 than that recorded
in most global markets, primarily reflecting the decline in equity prices of
resource companies. Equity prices had increased by 4 per cent since
the start of 2015 even though prices of resource companies had fallen further.

Members noted that Australian lending rates on the outstanding stock of housing and
business loans had continued to edge down since the December meeting. At the
time of the December meeting, financial market pricing had suggested some chance
of an easing in policy during 2015. This expectation strengthened somewhat
during January, and by the time of the February meeting pricing reflected a
two-thirds probability of a 25 basis point reduction in the cash rate
at that meeting, with the cash rate expected to be 2 per cent by
the end of the year.

International Economic Conditions

Members noted that growth of Australia's major trading partners had been around
its long-run average in 2014 and that early indications suggested this pace
had continued into 2015. Prices of a range of commodities, notably oil and
iron ore, had fallen further in recent months, reflecting a combination of
both lower growth in global demand for commodities and, more importantly, significant
increases in supply. Members also noted that the lower oil prices, if sustained,
would be positive for the growth of Australia's trading partners, which
are net importers of energy, and would continue to put downward pressure on
global prices of goods and services. Very accommodative global financial conditions
were also expected to support global growth in 2015. These positive effects
on trading partner growth, however, were expected to be largely offset in 2015
by a gradual decline in the pace of growth in China.

In China, economic growth had eased a little but was close to the authorities'
target for 2014. Growth of household consumption had held up over 2014, while
growth of investment and industrial production – which contribute significantly
to the demand for commodities – had trended lower over the past year
or so. Conditions in the residential property market had remained weak, and
measures introduced to support the market appear to have had only a modest
effect so far.

In Japan, economic activity had been weaker than expected since the increase in the
consumption tax in April 2014, but growth appeared to have resumed in the December
quarter and the labour market remained tight. However, inflation had declined
in recent months and remained well below the Bank of Japan's target. The
pace of growth had slowed a little in the rest of east Asia over 2014; as the
region as a whole is a net importer of oil, activity was likely to have been
supported by the decline in oil prices.

Members observed that the US economy had continued to strengthen, resulting in output
growing at an above-trend pace over the second half of 2014. Employment growth
had picked up further and the unemployment rate had continued to decline. Ongoing
strength in the labour market and lower gasoline prices had contributed to
a sharp rise in consumer sentiment. On the other hand, growth in the euro area
remained modest. Inflation had remained well below the ECB's target and
inflation expectations had declined further, prompting the ECB to implement
additional stimulus measures.

Domestic Economic Conditions

Members noted that the data released since the December meeting suggested that the
domestic economy had continued to grow at a below-trend pace over the second
half of 2014. Resource exports appeared to have continued growing in the December
quarter and growth was expected to remain strong, particularly as liquefied
natural gas (LNG) production came on line over the next year or so. The lower
exchange rate was expected to support growth of exports, particularly service
exports such as education and tourism.

Activity and prices in the housing market had continued to be bolstered by the low
level of lending rates and strong population growth. A range of indicators,
including residential building approvals, suggested further growth of dwelling
investment in the near term. Housing price inflation had moderated from the
rapid rates seen in late 2013, but remained high and in Sydney and Melbourne
had been well above the growth rate of household income. Growth of owner-occupier
housing credit had remained around 6 per cent in year-ended terms,
while investor credit had continued to grow at a noticeably faster rate.

Members were briefed on the main regulatory actions taken recently to address housing
risks in the domestic economy. In particular, the Australian Prudential Regulation
Authority (APRA) had announced several policy measures in early December to
reinforce sound residential mortgage lending practices. These policies included
clarification of prudential expectations on what constituted acceptable growth
in housing lending to investors and the possible steps that would be considered
if APRA's expectations were not met, such as increased capital requirements.

Turning to the business sector, members noted that mining investment had continued
to decline in the second half of 2014, and larger declines were expected over
2015 as existing projects were completed and very few new projects were likely
to proceed. Non-mining business investment had remained subdued and recent
data pointed to this continuing into the first half of 2015. Growth in public
demand was expected to be subdued over the next year or so.

Members observed that household consumption growth had picked up since its lows in
early 2013, supported by low interest rates and rising housing wealth. However,
consumption growth had remained below average. The recent decline in fuel prices
was expected to provide some offset for overall household incomes from weak
growth in labour incomes.

Members noted that the most recent data on the labour market had been a little more
positive than early in 2014. However, while employment growth had strengthened
somewhat over the past year, the unemployment rate had increased further over
2014 and average hours worked had remained below the levels of a few years
ago. Leading indicators of labour demand had changed little in recent months
and pointed to only modest employment growth in the months ahead.

Consumer price inflation had declined in year-ended terms, partly as a result of
a large fall in fuel prices in the December quarter and the effect of the repeal
of the carbon price on utility prices in the September quarter. Various measures
of underlying inflation, which largely abstract from these and other temporary
factors, had declined in year-ended terms to around 2¼ per cent.
Non-tradables inflation (excluding utility prices) had declined further in
year-ended terms to relatively low levels, consistent with subdued domestic
cost pressures. Prices of tradable items (excluding volatile items and tobacco)
were little changed in the December quarter, but were expected to face upward
pressure over time from the pass-through of the depreciation of the Australian
dollar since early 2013.

Turning their discussion to the economic outlook, members noted that staff forecasts
for output, which were conditioned on an assumption of no change in the cash
rate, had been revised lower in the near term. Recent data indicated that the
expected pick-up in consumption and non-mining business investment was likely
to occur later than had been previously anticipated, while the pick-up in LNG
exports over coming quarters was now likely to be less rapid. At the same time,
it was anticipated that the net effect of commodity price changes and the exchange
rate depreciation over the past three months would provide a positive impetus
to domestic growth over the next year or so. Overall, the underlying forces
driving growth remained much as they had been for some time and GDP growth
was still expected to pick up gradually to an above-trend pace in the latter
part of the forecast period.

The revisions to GDP growth implied that the unemployment rate would peak at a higher
rate and later than had been previously forecast, before declining gradually.
The inflation forecast had also been revised lower, reflecting the softer outlook
for labour and product markets as well as the recent fall in oil prices. Headline
inflation was expected to remain low for a time, before picking up at the end
of the forecast period. Underlying inflation was expected to remain well contained
and consistent with the target throughout the forecast period.

Members discussed a number of uncertainties around the forecasts. They noted that
developments in commodity markets, particularly the price of oil, would affect
future global growth and inflation outcomes. One area of uncertainty continued
to be the outlook for the Chinese property market and its implications for
Chinese demand for commodities. Members also noted that developments in commodity
markets were likely to be affected by supply factors; for instance, the response
of ‘unconventional’ oil producers in North America to lower oil
prices.

As usual, the path of the exchange rate remained a key area of uncertainty. Members
noted that the exchange rate had remained above most estimates of its fundamental
value, given the decline in commodity prices over the past year, and that future
exchange rate movements would be affected by market expectations for monetary
policy, both domestically and abroad. They noted that, all else being equal,
a sustained further depreciation would, if it occurred, stimulate growth in
the domestic economy and put some temporary upward pressure on inflation.

Members noted that there was considerable uncertainty around the timing and extent
of the expected increase in household consumption growth and non-mining business
investment. Although fundamental factors such as low interest rates and strong
population growth remained in place, they had not been sufficient to see a
significant pick-up in the growth of these variables or a decline in the degree
of spare capacity in the labour market. In addition, recent data suggested
that the expected improvement in economic conditions would occur later than
had been previously expected. Members commented that a strengthening in non-mining
investment was a necessary element for growth to pick up to an above-trend
pace, and noted the importance of confidence in underpinning such an outcome.
Indeed, an improvement in the appetite for businesses to take on risk had the
potential, should it occur, to lead to much stronger growth in non-mining business
investment than currently forecast.

Considerations for Monetary Policy

In assessing the appropriate stance for monetary policy in Australia, members noted
that the outlook for global economic growth was little changed, with Australia's
major trading partners still forecast to grow by around the pace of recent
years in 2015. Commodity prices, particularly those for iron ore and oil, had
declined over the past year largely in response to expansions in global supply,
though members judged that demand-side factors, such as the weakness in Chinese
property markets, had also played some role. Conditions in global financial
markets had remained very accommodative.

Domestically, over recent months there had been fewer indications of a near-term
strengthening in growth than previous forecasts would have implied. This included
survey measures of household and business confidence, which remained around
or even a bit below average. As a result, the revised staff forecasts –
which were based on an unchanged cash rate – suggested that GDP growth
would remain below trend over the course of this year, before gradually picking
up to an above-trend pace in 2016, somewhat later than had been previously
expected. The unemployment rate was therefore expected to peak a little higher
(and later) than in the previous forecast. The net effect of declining commodity
prices and the depreciation of the exchange rate was expected to boost growth
over the forecast period. Nonetheless, the higher degree of spare capacity
now in prospect and lower oil prices had led to a lowering of the forecast
for inflation, offset somewhat by the effects of the recent exchange rate depreciation.
The restrained pace of wage increases over the past year or so and accompanying
growth in productivity, which had dampened growth in unit labour costs, suggested
that low rates of inflation were likely to be sustained. In other respects,
the forces underpinning the outlook for domestic activity and inflation were
much as they had been for some time.

Members noted the current accommodative setting of monetary policy, which had been
providing support to domestic demand. They noted that the Australian dollar
had depreciated noticeably against a rising US dollar over recent months, although
less so against a basket of currencies, and that it remained above most estimates
of its fundamental value, particularly given the significant declines in key
commodity prices. Members agreed that a lower exchange rate was likely to be
needed to achieve balanced growth in the economy.

Given the large increases in housing prices in some cities and ongoing strength in
lending to investors in housing assets, members also agreed that developments
in the housing market would bear careful monitoring. They noted that it would
be important to assess the effects of the measures designed to reinforce sound
residential mortgage lending practices announced by APRA in December.

On the basis of their assessment of current conditions and taking into account the
revised forecasts, the Board judged that a further reduction in the cash rate
would be appropriate to provide additional support to demand, while inflation
outcomes were expected to remain consistent with the 2 to 3 per cent
target. In deciding the timing of such a change, members assessed arguments
for acting at this meeting or at the following meeting. On balance, they judged
that moving at this meeting, which offered the opportunity of early additional
communication in the forthcoming Statement on Monetary Policy, was the preferred course.

The Decision

The Board decided to lower the cash rate by 25 basis points to 2.25 per cent,
effective 4 February 2015.